Where is the money coming from?

It has been quite some time since I wrote about the mechanics of money, but today I am at it again. The catalyst is not, as some might expect, the recent discussions about the possibility of the US Treasury minting a trillion dollar coin, but rather a recent discussion I had with a banker about deposits on a small tropical island.

While deposit levels at banks in Australia are below upcoming regulatory minimums, leading to intense competition in the pricing of term deposits, the banker I spoke to was facing the opposite problem in the small nation of Paradise Island (not its real name).

As he told the story, despite offering rather unattractive interest rates on deposits, deposit balances had continued to grow. Worse, demand for loans was weak and so the bank was forced to keep growing balances on deposit with the island nation’s central bank. Since banks like to diversify their investments, this situation was not ideal. Ordinarily, he said, deposits would build up as exporters took in payments for their goods, but periodically these balances would be swept out again as they remitted their profits to offshore parent companies. This did not seem to be happening any more. Exactly why these deposits were growing was a mystery and, short of closing the doors of all their branches, he did not really know how to stop these balances from growing.

With years of reading Bill Mitchell under my belt, I knew that the way to think about this question was to take a macro perspective rather than thinking from the perspective of one bank.

The first thing I focused on was the balances with the central bank. A popular misconception is that banks can choose between holding deposits with the central bank or lending the money to their customers. In fact they cannot. The central bank itself only has two types of “customer”: banks and the government. You and I cannot walk into the central bank and open up an account. This means that the only thing that can happen with central bank balances is that they move around from one bank to another or to and fro between the government and banks.

Imagine for a moment that the bank arranges a $100,000 loan for me to buy a nice little shack on one of Paradise Island’s beaches. If the shack vendor banks with my bank, then our bank will see both its loans and its deposits increase by $100,000. On the other hand, if the vendor banks elsewhere, my bank will have to transfer $100,000 to the vendor’s bank. This is done by moving money between the banks’ respective accounts with the central bank. So, in this case, my bank has an increase in its loans of $100,000 and a decrease of $100,000 in its deposits with the central bank. But that central bank deposit has not left the system (and it has not gone to me). Rather, it has moved from one bank to another.

While there will be movements in central bank balances in this fashion from one bank to another in the normal course of business transactions, balances will tend to average out to reflect each bank’s market share. So, my banker friend is unlikely to be alone in seeing deposits with the central bank growing. Indeed, looking at the aggregate bank balances with the Paradise Island central bank, it becomes evident that there is a systematic trend.

Aggregate Balances with the Central Bank

So how does this happen? The most likely explanation is that the balances are coming from the government. As the government spends money, behind the scenes there will be money moving from the government’s account at the central bank to the accounts of commercial banks. This can happen if the government is running a deficit, spending more money than it is receiving. But that is not the case here. In fact, Paradise Island has been running a surplus of late.

A bit more digging through the national accounts reveals the answer. Paradise Island receives aid from larger developed nations and the government has been spending most, but not all of this aid. The twist is that this aid has come in the form of foreign currency, which the government then deposits with the central bank in return for local currency balances which it is then able to spend. As a result, the central bank’s foreign asset balances have also been steadily growing. The similarity of these two charts is no coincidence: the two sides of a balance sheets must balance and the growth in the central bank’s assets directly mirrors the growth in their liabilities, in the form of commercial bank deposits. This is an example of what is known as “grossing up the balance sheet”.

Foreign Assets of the Central Bank

So the growth in bank deposit balances with the central bank has nothing to do with Paradise Islanders hoarding money or choosing not to remit their profits offshore. Instead it is the direct result of the government spending its aid money. If the local banks want to have less of their money tied up in deposits with the central bank, rather than pointlessly trying to incentivise their customers to borrow or place their deposits elsewhere, they should consider encouraging the central bank to sell some of their foreign assets, reversing the grossing up of the balance sheet.

For me the most interesting aspect of this discussion is the fact that even if you can see exactly what is going on inside your own institution, it can be difficult to understand the workings of the system as a whole.

“If the local banks want to have less of their money tied up in deposits with the central bank, rather than pointlessly trying to incentivise their customers to borrow or place their deposits elsewhere, they should consider encouraging the central bank to sell some of their foreign assets, reversing the grossing up of the balance sheet.”

That is potentially risky, depending on what this aid is.

If it is loans denominated in foreign currency (USD, most likely), the central bank will be running down its foreign currency reserves. To the immediate effect on exchange rates and loan repayments, if interests rates were to spike, the country could find itself in trouble.

@Magpie in this case the aid is donations rather than loans, so in fact I would argue that is it more risky not selling the assets. At the moment the central bank is holding assets in foreign currency with (little or) no offsetting foreign currency liabilities. The bulk of the central bank’s liabilities are the (local currency) deposit balances of the commercial banks, so as it stands the central bank is running currency risk in this mismatch between the currency of assets and liabilities. Selling the assets would reduce both assets and liabilities and reduce this currency risk.

@Zebra but the point is that the money has been used! It’s just that the central bank’s balance sheet is grossed up with (foreign) assets and (domestic) liabilities. If the government hadn’t spent the money, the reserves with the local banks would not have grown.

I may have been a little subtle in the post, but the real problem here is that the growth in balances with the central bank represent an increase in exposure for the bank to the sovereign of “Paradise Island” but, for reasons of past experience, the bank does not really want too much exposure to this particular sovereign and is none to happy about the increase in exposure. The problem is that the bank this this is because its customers are saving, leading to deposit growth, and not either spending/borrowing or remitting their savings overseas. Of course even if their customers did all of those things, it would do nothing to reduce the exposure to the sovereign. Nothing the bank’s customers do will change reserve balances. That will only be affected by the actions of the central bank and/or the Treasury.